Does Corporate Performance Determine Capital Structure and Dividend Policy?
Michael W. Faulkender
University of Maryland - Robert H. Smith School of Business
Anjan V. Thakor
Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)
Todd T. Milbourn
Washington University in Saint Louis - Olin Business School
March 9, 2006
We present an integrated theory of capital structure and dividend policy in which both financial policy choices are driven by the same underlying factors and jointly determined as implicit governance mechanisms to allocate control over real (project choice) decisions between managers and investors. At one extreme is a very highly levered firm with very little equity. Such a firm puts the maximum control over project choice in the hands of investors. At the other extreme is an all-equity firm that pays no dividends. Such a firm puts maximum control in the hands of the manager. Between these two extremes is a continuum of control allocations determined by different debt-equity ratios and different dividend payout ratios. Higher debt-equity ratios and higher dividend payouts lead to greater investor control. Despite the absence of agency or asymmetric information problems, control matters because of a divergence of beliefs between the manager and investors that could lead to disagreement over the value-maximizing project choice. The extent of the potential disagreement depends upon the firm's prior performance. The manager sets the firm's dividend policy and capital structure to optimally trade off the value he attaches to being in control of project choice against the decline in stock price from taking control away from investors. We generate testable predictions from the theory and then test them empirically. These tests provide strong support for the theory.
Number of Pages in PDF File: 53
Keywords: Capital Structure, Dividend Policy, Disagreement
JEL Classification: G32, G35
Date posted: March 22, 2005